The Fundamentals of Investing – Part I

For a long while on this blog I’ve somewhat avoided discussing why I’ve invested in a particular stock partly because in some cases I really didn’t have a good reason for buying it in the first place. My very first stock I picked way back when I was a teenager, I picked because I liked the name.  Sad, but true. That changed in the last year when I took a class on basic accounting that helped me focus on how to decode a balance sheet from a company.  Now I’m skimming some fairly damn specific data before I buy a stock which I would like to share with you.

In terms of investor types I would typically fall into the value or income investor. So please do keep that in mind while reading this series.  If you have other goals you might end up looking at other factors.

Step 1 – Define Goals

Step one for me is to look at what businesses tend to have a long term profit and also tend to issue dividends. I don’t buy stocks for growth.  I’m after a nice stream of cash from a business and if I get a lot of growth, well that would be nice, but frankly I’m not counting on it most of the time.  So that tends to limit myself a fair bit on businesses, as I avoid start ups and IPOs are also off the table.  Both tend to be high risk ventures with no defined pay out.

As to what sectors I buy into I tend to look for companies that have repeat business on a monthly basis.  That way they have a nice stream of cash coming in to help pay me off in dividends.  So what companies are a good idea?  Look at the bills you pay monthly: water & sewer, electricity, phone and internet, bank fees and mortgage, natural gas to heat your home and gas for your car.  Based on those you look for utilities, telecom, banks (and/or Real Estate Income Trusts if you rent), oil and gas companies.

Step 2 – Determine Level of Risk

Unlike a lot of people who think the stock market is a great thing, I tend to think of it as highly risky.  It’s subject to mass panic, speculation and rumor to define what your portfolio is worth on a given day.  So I did my research and came to an interesting conclusion: you don’t need as much risk as you think.  It is possible to have a portfolio that is only 20% stocks that can still beat inflation (based on average return data from 1950 to 2007).  This isn’t to say you can’t have 100% in stocks, it all depends on your skill set and you comfort level.

In my case I’m planning on about 25% of portfolio in stocks.  Why so low?  Well in a nut shell my low expenses are a double edge sword, yes I get to retire early because of it, but on the other hand I don’t have a tonne of fat left in the budget.  I can’t afford to have massive drops in the portfolio if I had a 100% in stocks, so I aim lower and accept that I will be doing some work during my retirement years as a backup.

Step 3 – Find the Unloved

People screw up, it happens.  What is particularly interesting is when companies or governments screw up?  Why? Because panic and fear can be an investors best friend when looking for value.  I’ve seen it numerous times when people over react to some news and you end up with a really low share price and high yield.  I tend to look at news report of ‘the sky is falling’ to equal ‘let’s go shopping’.  Sort of like the last week or so is getting me scanning companies again seeing where some of my watch list is at.

A decant way to shift through a series of companies on most stock screeners is to use the P/E ratio.  Which is the stock price divided by the earnings per share of the company.  The lower the ratio indicates a depressed stock price.  A P/E of 20 is ok, but a P/E of 10 is ‘oh my god, what the hell happened to you to get crushed’ which means I would look into it further.  A good way to think of P/E is the number of years of earning per share earnings you would have to get in order to pay back your original purchase stock price.  It’s not like you would want to ever get a 100% of the earnings as a dividend, but it makes the ratio a little bit more easier to understand.

A similar method of looking for the unloved is to skim stocks by yield (how much of dividend are they paying divided by share price expressed as a percentage) .  The higher the yield the more likely the P/E is going to also be lower.  Just keep in mind…it it looks to good to be true, you might find a surprise in the financial reports.

Next up in the series – after you have found an unloved company, I’ll show you what I look for in its financial statements.

So what do you do differently when you start looking for a stock to buy?  Any tips or ideas to share?

12 thoughts on “The Fundamentals of Investing – Part I”

  1. Well I am kind of a unsophisticated amateur chicken regarding stocks though I did take a plunge in buying SLF @ $18.25 and AGF @ $15.50 back early Dec 2011. I simply picked them because of the dividend payout which is(at the price I paid) 6.9% for AGF and 7.9% for SLF. But as you say, beware when it is too much of a good thing and I am in danger of a dividend cut as both companies are hurting especially AGF(a financial management company). Plus AGF has dropped to $13 while SLF is around $22 currently. I only have 500 shares of each so it is only 10% of my liquid assets. I am in only for to get a little excitment in my otherwise boring investment world.I am tempted to pick up some more of AGF but am sitting on the fence since what little digging I did hinted at staffing troubles at that firm. The bottom line is that I am just sharing my situation, I have no advice, your advive sounds good as it is.

  2. One thing I would like to point out is that the P/E is not a benchmark. You can screen stocks based on a certain value but 10 is not universally a great value, nor does it mean that something happened to lower the price. It is good but a stock can trade around 10 times earnings and be properly valued. If you have a way to look it up checking what the P/E ratio has been historically is a good idea. If a stock traditionally trades at a P/E of 15 and is now at 10 then that is a good value, but if it usually trades at 10 then there is no value there. P/E often depends on the company, people are willing to pay a premium in relation to P/E for a great company like Google and maybe not someone like Chorus Aviation.

    That being said, I agree with your sentiment. Buying a company after bad news is a great way to find value. “Be greedy when others are fearful…” right?

    I like looking at the price of the stock in relation to the book value. If I can find a stock that is under the book value, that means that the company could go bankrupt and I would not lose money (I realize it doesn’t work exactly like that but the idea is on the right track. But this is different for each company just like the P/E.

    That is why I also look at the proximity of the 52 week low/high. I like the price to be closer to the low than the high, and the closer the better. For the most part the losers of today will be the winners of tomorrow. This opens me up to being burned by companies dropping further, but usually it does not matter to me.

    I am investing money now but I do not need the money for another 10-15 years. Even at that point I do not want to sell the investments, but use them for the income they provide. So while I like getting stocks at a good price I stick to large, strong companies with safe dividends or index funds. This makes the price I pay almost irrelevant except for getting the most for my money and the highest yield I can. I also do not rely on growth but I expect it.

  3. Ken Fisher calls it looking for a “glitch”. Exxon and BP after the oil spills kind of thing. Like Derek Foster making a ton on cheap tobacco stock after the tobacco industry lawsuits.
    And pretty much anyone could have made money betting on the S&P eventually going up in late 08-09 when the whole shebang had a glitch – if they’d had cash sitting around to deploy which I guess most people didn’t. Maybe that’s a warning to not be fully invested all the time.

  4. @Canuckguy,

    Ugh, typo. Thanks.

    Also thanks for providing some example stocks, since I haven’t finished doing post #2 of this series perhaps I’ll use one as example.

    @Poor Student,

    Oh, good point. All screens are just that screens, they help you find potential stocks, it doesn’t provide you with any assure at this stage.

    I also like your ideas for other things to look at. Thanks for sharing.

    @Financial Uproar,

    Your welcome. See I’m not made of stone…I do listen to you guys. 😉 Also your timing was well done as I had this idea rolling around my head for months. I just wasn’t sure if I wanted to do it on the blog or perhaps a freelance series.

    @Jacq,

    “Glitch” is a good title. While I look for those, I don’t depend on them all the time. Ugh, the problems with series posts…some days you just want to write a massive one some days and put it all out there at once.

    @hockeyball,

    Will do…you just need to wait a week.

    Tim

  5. @canadianinvestor,

    The TFSA accounts are all individual stocks, then the investment accounts are also all individual stocks (in both cases including some REIT). Then the RRSP is all mutual funds (index) with 70% of those accounts in stocks and 30% bonds funds. The pension is made up with mutual funds, but the costs are similar to a ETF. Feel free to do the math on my last net worth statement to get percentage values on an overall basis (I only pull that data like once a year, so I don’t have a recent set of numbers to put up).

    Does that answer the question?

    Tim

  6. @CanadianDream
    Yes it does.
    I was wondering if you actually invest in the market, of just “dabble”, with the rest in mutual funds.
    It “frames” the discussion better. I know, a little better, where you are coming from.
    Thank you for taking the time to respond to my question…

  7. @canadianmdinvestor,

    Ah, thanks for letting me know. Good point, to date I don’t have that much in individual stocks, but next year I will be investing a lot of money. So it is getting a lot more critical for me to firm up what I’ve been doing. So writing it all down is useful for me and besides a good debate on points of view is always a good thing.

    Tim

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